Posts Tagged ‘free market’

Federalism: New Arguments for an Old Idea

Wednesday, January 27th, 2010

Two good pieces have come out recently advocating distributing power away from the federal government in Washington towards the states and the counties: one by Alex Castellanos and the other by Arnold Kling. Castellanos writes to give the GOP a message for the 2010 electoral cycle that can reach the ears of the Millennial generation. He puts the ideas of individual liberty and free markets in terms of networks, such as Facebook. Free markets work, he argues, because their network-like structure allows coordination among individuals more efficiently than a hierarchical, top-down, command structure.

Kling, on the other hand, notes that those hierarchical command structures simply don’t work. A national government must institute a uniform policy, which can never satisfy everyone in a large country like the United States. State governments can create a variety of policies, each tailored to the different preferences of their residents. State and local governments can also respond more quickly to policy challenges because of the reduced chain of command.

Yet, neither of these articles presents any radically new ideas. James Madison outlined the federal nature of the Constitution in Federalist No. 10 and Federalist No. 39. In the Federalist No. 10, Madison argues for a large nation, so as to diminish the influence of any one faction in the body politic. With many competing interests, a government could not pass laws that benefited one group at the expense of another, such as the recent Senate heath care bill where all 49 states would pay for the costs of Nebraska’s heath care.

In Federalist No. 39, Madison explains how the Constitution conforms to republican principles and creates a government that is neither wholly federal nor wholly national. Though the federal government derives some of its powers directly from the people, but it mostly coordinates actions between the states and leaves most of the powers of government to the states:

The idea of a national government involves in it, not only an authority over the individual citizens, but an indefinite supremacy over all persons and things, so far as they are objects of lawful government. Among a people consolidated into one nation, this supremacy is completely vested in the national legislature. Among communities united for particular purposes, it is vested partly in the general and partly in the municipal legislatures. In the former case, all local authorities are subordinate to the supreme; and may be controlled, directed, or abolished by it at pleasure. In the latter, the local or municipal authorities form distinct and independent portions of the supremacy, no more subject, within their respective spheres, to the general authority, than the general authority is subject to them, within its own sphere. In this relation, then, the proposed government cannot be deemed a NATIONAL one; since its jurisdiction extends to certain enumerated objects only, and leaves to the several States a residuary and inviolable sovereignty over all other objects.

You can find the complete Federalist Papers here: It’s like an owner’s manual for the Republic.

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Fed to Approve Bankers’ Compensation

Thursday, September 24th, 2009

The Federal Reserve Board plans to scrutinze the comensation of employees at over 5,000 U.S. banks, particuarly those of executives.  The Fed would not directly set compensation, but could intervene in cases where it thinks that compensation encourages too much risk.

On one level, I think this is a good idea.  Compensation policies for bank employees should reward activity that increases the long-term profitability and soundness of a bank.  They should not encourage employees to pursue profits in the short-term at the expense of the long-run.  For instance, paying employees on the amount of loans they write encourages them to make loans without regard to the credit-worthiness of the borrower.  If an employee turns down riskier loans, he may have helped the long-run stability of his company, but at the expense of a portion of his annual salary.  Why would he do such a thing, especially if he only plans to stay at the firm for a few years?

But in order for this government policy to be helpful, or even necessary, we first must assume that bank shareholders are incapable of setting up contracts that secure long-term growth in the value of their stock.  If it’s easy to set up such a contract, I see no reason why bank shareholders would not do so themselves.  If it’s not easy to write such a contract, what makes Federal Reserve more capable to write those contracts than the shareholders themselves (or rather, than any consultants with expertise in agency theory, which invites yet another agency problem, but that’s another story).

In the previous paragraph, I assumed that bank shareholders rationally choose the maximize long-run profits instead of short-run profits.  Might bank boards act rationally by pursuit of short-term profits at the expense of the bank’s long-term stability?  It certainly makes sense when they have an implicit guarantee of their liabilities from the government.  Then, if the bank makes big profits, they go to the shareholders, but if it makes big losses, they get foisted off to the government.  Such a guarantee encourages bank owners to play a game of “heads I win, tails you lose.”

It makes more sense to me to remove the implicit government protection from failure rather than simultaneously operate two policies that both encourage and discourage risky behavior.  However, operating both policies give the Fed a measure of control over the growth of the economy that it would not have otherwise.  Unless it is managed perfectly, such control will reduce the variability in the cyclical fluctuations of the economy at the expense of a lower long-term growth rate.  If regulations push bank executive compensation below their fair market values, then the financial sector will struggle to get the resources it needs to provide the amount of credit it would have without regulation, which will hamper the growth of small businesses.  The Fed’s move to examine pay structures indicates that it thinks the cumulative economic loss from a lower growth rate is less than the potential loss that could occur during a collapse.  That, or it overestimates its own ability to correctly determine compensation for bank employees.

Ultimately, the success of this new policy depends on how heavily the Fed applies.  If used sparingly, with an eye to the health of the overall financial system, the pay policy will help the Fed nudge the financial sector into a region of stability.  If used often, then it will restrict the proper functioning of the credit markets, interfere with the freedom of individuals to agree to contracts, and do little to protect the health of the financial system.

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A Defense of Markets from the SEC Chairman

Thursday, December 11th, 2008

I’d like to highlight a selection of Christopher Cox’s editorial in today’s Wall Street Journal:

“The normative judgment implicit in this legislative and regulatory scheme is that markets are good. So long as they are in fact operating efficiently, competitively, openly and honestly, they are good for consumers, investors, producers and our entire economy. We have not spent enough time reminding ourselves of this essential premise during the past several months, when events have called it into question. But because the idea of the market is so fundamental to everything that the SEC does, we must focus again on why we value markets so highly.

Our emphasis on private ownership is directly tied to America’s dedication to individual freedom. It’s in our DNA. It is, in large part, why the United States came to be at all. Our Declaration of Independence is a recitation of the abuses of excessive government power. Our Constitution is a brilliantly crafted system of checks and balances to prevent that abuse by limiting government’s authority over individuals — including in the economic realm, where we’re guaranteed our constitutional rights to liberty and property, to freedom from expropriation, and to freedom of contract.

But beyond that, beyond ideals of freedom, the national preference for private ownership is also based on the most basic practicality: It works. America’s rise from New World outpost to global superpower was fueled by the dramatic growth of our free enterprise economy into the world’s largest. Free enterprise has produced spectacular results. Compared to other national economies with substantial government ownership and central planning, America’s economy has been more creative, resilient and dynamic.

We’ve found that decentralized decision-making, in which millions of independent economic actors make judgments using their own money, results in the wisest allocation of scarce resources across our complex society. And we’ve found the market to be more reliable in heeding price signals and meting out discipline to failing enterprises than government could ever be.”

It’s good to see that at least one government official still believes in a limited role for the government in ensuring the functionality of markets.  I think Christopher Cox has done a great job as the Chairman of the SEC (and as such a member of the oversight boards for the Federal Housing Finance Agency (FHFA), the new regulator for Fannie Mae and Freddie Mac, and the Troubled Asset Relief Program (TARP), which provides government capital for struggling banks).  I am less impressed with Treasury’s execution of the TARP, which appears to be more of the limited, short-term thinking that was prevalent in the run-up to this financial crisis.  Unfortunately, Mr. Cox stopped his essay short of providing a plan for the exit strategy that he supports.

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The We Deserve It Dividend

Wednesday, October 1st, 2008

It’s understandable for most people to see that Congress is proposing giving (actually it’s trading money for assets, which is generally described as buying, but I’ll use the verb most that most people hear when its explained to them) Wall Street $700 billion and think, “Why can’t I get some of that money?”  A <a href=”http://www.snopes.com/politics/taxes/dividend.asp”>recent email</a> has circulated around the Internet, suggesting that instead of giving (there’s that word again) AIG $85 billion, we give that out to every American taxpayer over the age of 18 as a “We Deserve It Dividend.”

 

That’s a nice idea, but here’s the problem with it.  How do we pay for it?  We have two options:

 

1. Borrow the money.  The government can issue $85 billion in new Treasury bonds to raise the money.  The good news about that is that with the uncertainty about the soundness of any asset besides gold or U.S. Treasury bonds, demand for T-bills is high, which means that prices are high and therefore interest rates are low.  And since inflation is at its highest point since 1991 (5.37% in August), the money that the government would pay back, plus interest, would be worth less when it is due than it is now.  But that really just refinancing private goods with public money; yes, everyone could pay off their mortgages, but we would all still owe the same amount of money, just to a different creditor.  And I can assure you that once people shifted their debt from private mortgages to public Treasury bills they will just double down on their loans.

 

2. Just print new money.  The upside: no new borrowing and no addition to the deficit.  But be careful when someone promises you something for nothing.  Everyone would know that the new $85 billion has no additional value.  It has done nothing to redistribute real assets; it has just increased the total pool of dollars that everyone has to bid for assets.  Expect prices, especially gas and food prices to rise accordingly.  Additionally, each individual dollar will be worth less, so expect prices on imported goods, like crude oil, to rise even further.  Once inflation expectations set in, they can be very hard to break.  If that were to happen, you can expect interest rates to rise and a recession to follow, like what happened in the early eighties when Paul Volker let the Federal Funds rate rise to 20% to stop the inflation of the seventies.

 

The $85 billion “bailout” of AIG is actually a credit line that has been extended to them by the Federal Reserve.  It is up to AIG whether or not they take out any money from this credit line.  The catch is that the interest rate on any loans from the credit facility is 8.5 point over LIBOR, which is about 4% right now.  So the toal interest rate is about 12.5%, which is about the same rate I’m paying on my credit card.  Additionally, the loans that AIG would take out would be secured by a preferred equity stake of up to 80% for the Federal Reserve, which would cause the shareholders of AIG to take a loss.  This whole idea was so unpleasant to AIG shareholders that shortly after the bailout was announced they scrambled to find enough equity to avoid having to use the Fed’s credit line.

 

I take a lot of calls from constituents who don’t understand what caused the problem and certainly don’t understand what is being proposed to fix it.  All they know is that they don’t want to pay to save the rich guys on Wall Street who caused this problem.  They repeat what they hear from Rush Limbaugh and Sean Hannity that we should let these banks fail and let the free market work itself out.  Any bailout is the first step to socialism.  What they don’t understand is that the Great Depression happened because the government sat on its hands during a panic and let a quarter of the existing banks fail.  GDP dropped to almost half of what it was before the stock market crash during the Depression’s worst year and didn’t recover until ten years after the crash.  The free market cannot work itself out because the participants are in a panic and hoarding cash until the storm passes.  By the time anyone has the courage to step in the market, everything will be gone.  I talked to a guy today who saw his 401(k) fall from $50 a share to $1.

 

Goldman Sachs has been so successful as an investment bank (at least it used to be an investment bank), because it was “long-term greedy” — it passed up short-term gains when it might risk losing business over the long-term.  Here, the proper solution is one that is “long-term free-market.”  People who advocate a free market solution to this have no idea that free markets cannot provide the solution unless investors are acting rationally.  They have no idea how long, painful, and costly it will be to fix this if it is allowed to play itself out.  And they have no idea how much the fundamentals of the economy will change towards socialism if the complete failure does occur, the Representatives who supported this thing get voted out of office, and a Democratic administration gets to revamp the economy in order to bring it out of a Depression.  In order to protect the long-term health of our economy, we must do something to backstop the slide in the financial markets.

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